Trump Trades Blows with China

The International Monetary Fund has downgraded world growth forecasts, warning that a U.S.-China trade war will hit economic growth. The IMF is now predicting 3.7 per cent global growth in both 2018 and 2019, down from 3.9 per cent for both years.

President Donald Trump has slapped tariffs on $250 billion worth of Chinese goods this year, and Beijing has retaliated with levies of $110 billion on American products. The IMF’s projections don’t consider Trump’s threat to expand the tariffs to effectively all of the more than $500 billion in goods the U.S. bought from China last year. If the trade war continues, it could take a significant bite out of global growth, according to the Fund. It estimates global output could fall by more than 0.8 percent in 2020 and remain 0.4 percent below its trend line over the long term. This is in a scenario where Trump follows through on all his threats, including global duties on cars. According to IMF models, output could fall by more than 1.6 percent in China and over 0.9 percent in the U.S. next year.

Following this news, we thought it would be a timely opportunity to review the potential impacts of the trade wars on securities lending.

U.S. IMPACT

The sectors that have the greatest exposure to China’s economy are information technology, materials, industrials, consumer staples and energy sectors. The U.S. tariffs target the high-end technology products made in China. That could mean that companies such as Apple Inc. and Lenovo Group Ltd. that operate significant Chinese production bases, face higher costs or supply-chain disruption. Whilst the percentage of free float on loan has been modest in these companies, we are seeing a higher correlation in companies that use aluminum or steel. Almost any product that uses aluminum or steel is already being affected. In its first-quarter earnings call, the household appliance maker Whirlpool said the steel and aluminum tariffs would cost the company an extra $50m. Stock in Campbell Soup, the tinned food processor headquartered in New Jersey, has dropped 14% since the company identified steel tariffs as a potential hit to its bottom line in 2019. In the auto industry, China plans to impose tariffs on most vehicles including electric cars. Tesla Inc. is at risk as it relies on American-made vehicles for all its Chinese sales. Other U.S. car makers such as General Motors Co. and Ford Motor Co. also manufacture in China. Lastly, Harley-Davidson has been the first high profile company to plan to shift production from the U.S. to Europe to avoid of up to $100m of extra charges over the next couple of years.

The graph below shows the percentage of free float on loan change for key companies: Boeing, Micron, Caterpillar, Skyworks, Maxim, Marvell, Qualcomm, Broadcom, Harley Davidson, Whirlpool, Campbell and Ford Motor.

It is also worth noting that securities lending demand has been strong for Chinese ADR/ADS’s, such as Cango Inc, Aurora Mobile Limited and Pinduoduo. However, the cross-border IPOs have been rattled by trade tensions and deals are getting downsized. If the trade war continues to escalate then we would expect the recent trend to continue.

EUROPEAN IMPACT

 

The biggest impact we have seen from a securities lending perspective is from the mining and exploration companies.  The imposed 10% tariff on steel and 25% tariff on aluminum has had a substantial effect on the percentage of free float on loan. We have also seen demand driven from threats of Trump imposing tariffs on European cars. Germany is clearly most concerned with a possible 20% tariff to be imposed which has given a strong rise in percentage of free float on loan in Volkswagen and BMW. The below graph represents the percentage of free float on loan change for Rio Tinto, Ferrexpo, Volkswagen and BMW.

ASIAN IMPACT

Securities lending demand in Asia has been focused in Hong Kong, Japan and Taiwan. We have seen over a 50% increase to the percentage of free float on loan in a wide range of Chinese and Japanese manufacturing companies such as AAC Technologies Holdings Inc, Weichai Power Co Ltd, Fuyao Glass Industry Group Co Ltd, Shenzhou International Group Holdings, Mitsubishi Chemical, Honda Motor Co Ltd., and food and beverage company Suntory Beverage and Food Ltd. Like the U.S. market, all these stocks are very liquid in the Asian securities lending market so have remained trading at low fees. China used to be a cheap base for Taiwanese manufacturers. However, with production costs increasing, and Taiwanese firms wanting to avoid being hit with high tariffs from the U.S., they are now looking for new production sites in the ASEAN region. The focused stocks that have seen a high percentage of on loan value and trading special are Delta Electronics and Pegatron. The below graph represents the percentage of free float on loan change on the above companies listed in Asia.

MACRO OUTLOOK

While an expanded trade war could lead to a “lose-lose” outcome, the greatest impact could come for stocks in the U.S., as they are more exposed to the Chinese economy. Whether these exposures result in greater risk, or in opportunity, depends on how China and the U.S. decide to place barriers on each other’s imports. What has become evident already is that many companies are not waiting to see how things unfold. We have started so see companies relocating, increasing production in existing factories outside of the U.S. and/or looking for alternative countries for manufacturing.

In terms of interest rate expectations, the FED may have to revisit its U.S. economic outlook to the downside as many businesses are delaying investment decisions until the trade outlook is less uncertain. With so much uncertainty, global investment falls, companies hoard cash, and the real economy could well suffer a recession.

SECURITIES LENDING OUTLOOK

We have seen that most stocks with an increase in percentage of free float have remained at low fees due to high liquidity in the lending pool. In the short run, as the equity markets seems to have shrugged off the tariffs, there is likely to be limited impact for securities lending. In the longer term, as the tariffs start to affect company financials, essentially through higher cost of production, we would expect short demand to return and with greater conviction. We would also expect the trickle-down effect to hit the smaller/mid cap companies who feed into the large cap companies. These securities are likely to generate favorable securities lending revenue due to their liquidity in the lending pool being smaller. As you would expect, the correlation of short interest globally is highest for the manufacturing sector. Whilst fees have remained modest, we would expect activity to gain momentum into 2019 when you would expect the effects of the tariffs to filter through.